Oil prices

Flaring up?

Might recovery around the world be checked by dearer oil?

THE spectre of another oil crisis all of a sudden looms large, and this at a time when the world economy has barely begun to recover from last year's recession. There are fears that conflict in the Middle East could once again send oil prices sharply higher—and send world economic output tumbling. To judge by the rise in oil prices thus far, such fears are overdone. But do not underestimate the power of oil.

Between December and last week the price of West Texas Intermediate crude rose from $18 to almost $28 a barrel, before slipping back somewhat. Some of the increase is due to stronger demand as economies pick up, but most reflects tensions in the Middle East and the risk of a supply shortage. This week Iraq announced that it is suspending oil exports for a month, in protest against Israel's invasion of Palestinian areas of the West Bank. Iran and Libya have muttered about following suit, though not with conviction. Concerns about an oil shortage have been sharpened by a politically motivated strike in Venezuela, the world's fourth-biggest oil exporter, which has disrupted production (see article).

None of this, however, yet adds up to an oil crisis. Saudi Arabia, the world's biggest producer, has firmly rejected the idea of an Arab oil embargo. It is likely to pump out more oil if prices continue to rise, since it is in the kingdom's interest to stabilise prices in order to preserve long-term demand. Saudi Arabia and Kuwait, which is also unlikely to join any oil embargo, together have almost 4m barrels a day of spare capacity. That should be enough to offset any prospective shortfall from Iraq and Venezuela, which have been exporting 1.7m and 2m barrels a day respectively.

If Libya and Iran joined a putative embargo, however, that would create a further shortfall of 3.5m barrels a day—too much even for the Saudis, as swing producers, to fill. Spare oil capacity outside OPEC might fill the gap eventually—but in the short term, the oil price would soar.

Economists have accordingly pulled out their ready-reckoners for how various oil-price rises might affect growth. The world is less dependent on oil than it was, thanks to improved efficiency in the use of energy and to a shift away from heavy industry. Yet oil still has the power to shock.

Over the past three decades oil prices have jumped sharply on four occasions: in 1973 after an OPEC embargo, in 1979 after the Iranian revolution, in 1990 after Iraq's invasion of Kuwait, and in 1999-2000 as the world economy boomed and OPEC cut its production. Each time oil prices more than tripled, and a downturn in the world economy followed. America's recession last year was caused largely by the bursting of the high-tech bubble, but the rise in the oil price over the previous two years, from around $10 a barrel to a peak of $37, surely played a part.

Compared with previous oil crises, the recent jump in the oil price has been modest. The present price is still slightly below its average of $28 a barrel in 2000-01. In real terms, oil costs less than half what it did at its peak in 1990. But if the price rose much above $30 and stayed there, it would dent growth. The OECD estimates that a rise in oil prices of $10 a barrel would increase inflation in rich countries by half a percentage point in the first year and reduce growth by quarter of a point. The impact on Europe and Japan would be bigger than in the United States. America guzzles more oil, but it is also a producer, so its net oil imports are smaller.

The economics team at Morgan Stanley has looked at several scenarios. On the worst assumptions, it calculates that if prices rose to $40 a barrel and stayed there until the end of the year, world growth in 2002 would be cut from 2.6% to 1.8%, the same as in 2001. If that happened, 2001 and 2002 would be the slowest two consecutive years ever of recorded growth.

Slippery numbers

The snag with ready-reckoners is that they look only at the direct impact, and ignore the possible effects of a jump in oil prices on consumer and business sentiment—or on share prices. By many measures, America's stockmarket remains overvalued relative to any likely future growth in profits. An oil-price hike might quickly bring share prices back down to earth, with more severe consequences for growth.

The impact of oil prices also hangs on how central banks respond. Conventionally, a rise in oil prices is thought to be inflationary, so the correct response from central banks is to raise interest rates. Higher oil prices certainly push up the headline inflation rate. But in the longer term, the impact is more subtle.

Higher oil prices affect economies in two main ways. First, a rise in oil prices delivers a negative supply-side shock. It raises firms' input costs: for any given output price, firms therefore produce less. Second, a rise in oil prices represents a shift in the terms of trade from oil-consuming countries to oil producers. As a result, real incomes and spending are reduced among the oil consumers. The overall impact on world demand depends on whether oil exporters save their windfall or spend it on imports from oil-consuming countries.

In economists' jargon, a rise in the oil price produces a downward shift in both aggregate supply and aggregate demand. This implies a fall in output, but the impact on underlying inflation is not clear-cut. Several factors are at play: notably, whether higher headline inflation feeds into higher wages.

Whether central banks should raise interest rates to prevent higher inflation or cut rates to cushion the slowdown depends partly on the cyclical position of the economy. If the economy is already overheating, with squeaky tight labour markets, a rise in oil prices is more likely to feed into wages and push up core inflation. Central banks might then need to tighten policy. The four previous big oil-price hikes all took place in inflationary conditions at a late stage of economic booms. In today's environment, where spare capacity is ample and firms have little pricing power, higher oil prices are much more likely to squeeze profits than to push up inflation. This underlines the risk that the chief impact of higher oil prices might come through a slump in share prices.

Economists at CSFB think that the European Central Bank is likely to raise interest rates if higher oil prices push up the euro area's headline inflation rate, which is already above its official ceiling of 2%. On the other hand, America's Federal Reserve, CSFB says, is less likely to worry about the threat to inflation from higher oil prices than about the risk of slower growth.

That is probably right. Although America's economy grew by an estimated 5% at an annual rate in the first quarter of this year, that was largely because companies rebuilt their inventories. Business investment is still weak, and a robust recovery relies upon debt-laden consumers continuing to spend. If higher oil prices and a slump in share prices were to squeeze spending by households and firms, America could easily tip back into recession. With interest rates already as low as 1.75%, the Fed has little room to cut further.

Were oil prices to stay around their present levels, this would be a mere bump in the road for the world economy, rather than a head-on crash. But if prices climb higher, the risk to growth would come from another fall in share prices and the failure of some central banks to recognise that they do not need to tighten policy.